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The Complete Guide to

Futures TradingWhat You Need to Know about

the Risks and Rewards

REFCO PRIVATECLIENT GROUP

John Wiley & Sons, Inc.

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Futures Trading


Futures TradingWhat You Need to Know about

the Risks and Rewards

REFCO PRIVATECLIENT GROUP

John Wiley & Sons, Inc.

Copyright 2005 by Refco Private Client Group. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any formor by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except aspermitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the priorwritten permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-646-8600, or on the web at www.copyright.com. Requests to the Publisher for permissionshould be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street,Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008, or online at www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and the author have used their bestefforts in preparing this book, they make no representations or warranties with respect to theaccuracy or completeness of the contents of this book and specifically disclaim any impliedwarranties of merchantability or fitness for a particular purpose. No warranty may be created orextended by sales representatives or written sales materials. The advice and strategies containedherein may not be suitable for your situation. You should consult with a professional whereappropriate. Neither the publisher nor the author shall be liable for any loss of profit or any othercommercial damages, including but not limited to special, incidental, consequential, or other damages.

FUTURES TRADING INVOLVES THE SUBSTANTIAL RISK OF LOSS AND IS NOT SUITABLE FORALL INVESTORS.

Designations used by companies to distinguish their products are often claimed by trademarks. In allinstances where the author or publisher is aware of a claim, the product names appear in InitialCapital letters. Readers, however, should contact the appropriate companies for more completeinformation regarding trademarks and registration.

For general information about our other products and services, please contact our Customer CareDepartment within the United States at 800-762-2974, outside the United States at 317-572-3993 or fax 317-572-4002.

Wiley also publishes its books in a variety of electronic formats. Some content that appears in printmay not be available in electronic books. For more information about Wiley products, visit our website at www.wiley.com.

Library of Congress Cataloging-in-Publication Data:

The complete guide to futures trading : what you need to know about the risks and rewards.

p. cm.The author is under a companys name: Refco Private Client Group.ISBN-13 978-0-471-48802-6 (pbk.)ISBN-10 0-471-48802-X (pbk.)

1. Financial futures. I. Refco Private Client Group.HG6024.3.C67 2005332.64'52dc22 2005003024

Printed in the United States of America.

10 9 8 7 6 5 4 3 2 1

www.wiley.com

v

Contents

Foreword ix

Preface xi

About the Contributors xiii

CHAPTER 1 Futures: The Investment for the Twenty-First Century 1Mark Sachs

Historical Roots 2

What Futures Are 2

What Futures Are Not 4

Who Trades Futures? 9

Making Your Choice 11

CHAPTER 2 Becoming a Futures Trader 13Dan McMullin

Trading Decision Issues 14

Fundamental Analysis Highlights 18

Technical Analysis Highlights 25

Putting It All Together 56

CHAPTER 3 Trading with a Broker as a Partner 59Jim Gombas

What a Broker Can Offer 59

Options versus Futures 65

Market Should Fit Strategy 66

Paper Trading, Back-Testing 67

CHAPTER 4 Letting the Pros Trade Your Account 69Carol Dannenhauer

Why Managed Futures? 70

Where Do You Start? 74

Evaluating Trading Programs 76

Investing in Managed Futures 80

CHAPTER 5 Using an Auto-Executing Trading System 83Herb Kral

Why an Auto-Executing Trading System? 83

Look at Yourself First 85

What to Look for in a Trading System 86

Why Successful Systems May Fail 88

Summing up Systems 89

CHAPTER 6 Resources for the Self-Directed Trader 91David Howe

Brokerage Firm Choice 91

Trading Platform 93

Trading Support Tools 95

Match Resources to Your Needs 98

CHAPTER 7 Knowing Your Margins and Marching Orders 99Greg Gulotta

Trading on Margin 99

Order Types 101

Placing Orders 108

Tips about Trading Mechanics 110

Connectivity Issues and Questions 113

CHAPTER 8 Futures: Diverse Markets You Can Trade 115Susan Abbott Gidel

Equity-Based Futures 117

Financial Instruments 122

Commodities 127

CHAPTER 9 Options on Futures: A Flexible Trading Tool 139Dan McMullin

Issues to Consider When Investing in Futures Options 140

Mechanics of Futures Options 144

Basic Futures Options Strategies 151

vi CONTENTS

CHAPTER 10 Forex: Another Opportunity for Traders 167Phillip Fondren

What Is the Forex Market? 167

Exchange Rates and Central Banks 171

The Trading Instrument 172

Spot Market versus Futures Market 176

Electronic Trading 177

Costs of Trading 178

CHAPTER 11 Deciding to Trade 181Mark Sachs

The Money Factor 181

Time for Trading 183

Knowing the Market 183

Who Are You? 183

Your Trading Plan 184

Picking a Brokerage Firm 186

CHAPTER 12 Opening an Account 189Nancy Westwick

Opening Account Information 190

Risk Disclosures 190

Type of Account 192

Power of Attorney 193

Customer Identification (Patriot Act Requirements) 193

Single-Stock Futures 193

Account Funding Requirements 194

Margin Calls 194

Resolving Disputes 195

CHAPTER 13 The Tax Factor for Traders 197Philip Silverman

Section 1256 Contracts 197

How to Report Gains or Losses 199

Special Considerations 201

Contents vii

CHAPTER 14 The Business of Futures: Who Does What 203Laura Oatney

Regulatory Structure 203

Futures Exchanges 205

Clearinghouses 205

Futures Industry Professionals 207

APPENDIX A Domestic and International Futures Contract Volume 211

APPENDIX B Futures Contract Specifications 251

APPENDIX C Speculative Margins 269

Glossary 273

Index 289

viii CONTENTS

ix

Foreword

As its title suggests, this landmark book makes futures trading accessible to main-stream individual investors. The determination of whether futures are right foryour portfolio remains with each individual, but The Complete Guide to FuturesTrading can serve as an expert advisor to help you make informed decisionsabout how to participate in the exciting derivatives markets.

Written by experienced practitioners from Refco, a diversified global financialservices organization, and Refco Private Client Group, previously known as Lind-Waldock, a leading broker for individual futures traders, the book answers thequestions a newcomer to futures and commodities trading might have about whatit takes to establish an account and make a commitment to trading.

This is not a book about trading futures, however. It does not offer tips abouta particular technical or fundamental approach to the markets. Instead, it servesas a bridge between having an interest in futuresyet knowing little about how togo about acting on that interestand placing a trading order in your futures ac-count. After reading it, you will know what questions to ask yourself and your bro-kers and other industry professionals when getting ready to establish a futurestrading account.

Readers who are new to futures trading will be interested in the range of top-ics covered, because it will answer questions about how to get started tradingcommodity futures:

Which type of account is best for me? What should I know about risk, leverage, and margin? Is my comfort level with risk in line with what futures trading provides? What questions should I ask when looking for a brokerage relationship? How are futures taxed? What resources do I need as a futures trader? What are the different ways to approach making a trading decision? What are the various types of orders I can use? What markets can I trade?

Clearly written by contributors with a depth of practical understanding thatcomes from years in the futures industry, The Complete Guide to Futures Trading

addresses these issues and others in a well-organized, easy-to-follow style. Aschief executive officer of the largest financial exchange in the world for trading fu-tures and options, I can wholeheartedly recommend this volume for the readerwho wants to learn the fundamentals of investing in futures.

CRAIG S. DONOHUEChief Executive OfficerChicago Mercantile ExchangeMay 2005

CME is the largest financial exchange in the world for trading futures and op-tions on futuresserving risk-management needs globally through a diverserange of derivatives products on its CME Globex electronic trading platformas well as on its trading floors. Today the company is in 27 countries, withmore than 740 direct customer connections, annual sales in excess of $735 mil-lion, and 1,300 employees. In 2004, CME handled nearly 800 million contractswith an underlying value of $463 trillion. The first financial exchange in theUnited States to go public, CME is traded on the New York Stock Exchange andNasdaq under the symbol CME and has a market value of nearly $7 billion.

x FOREWORD

xi

Preface

Futures are the investment of the twenty-first century.At the beginning of the twentieth century, investing in stocks was consid-ered a risky proposition for individuals, who were advised to stick to buyingbonds. Now, over 50 percent of U.S. households invest in the stock market directlyor indirectly through mutual fund holdingseven in retirement accounts. At RefcoPrivate Client Group, we believe writers of the twenty-second century lookingback on the twenty-first will say the same about investment in futures.

Although U.S. futures markets began in the mid-1800s, they didnt haveglobal significance until the 1980s, when companies and governments worldwideembraced the instruments as financial management tools. Futures markets havealways been about price discovery and transfer of risk, so are ideally suited toenvironments of uncertainty and high volatilityan apt description of the past30 years.

The collapse of the gold standard in 1972 led to free-floating currency ex-change ratesand the first financial futures contracts, foreign exchange, at theChicago Mercantile Exchange. Inflation throughout the 1970s and early 1980s ledto record-high interest ratesand new futures contracts in U.S. Treasuries andEurodollars. Stock index futures came into their own during the bull market of the1980s, and were an inextricable part of the institutional investors playbook withinless than five years.

Now, futures are part of a savvy individual investors playbook, too.Technological advancesmost significantly, the Internethave transformed

the futures trading landscape. Today, individual investors are on a level playingfield with professional traders and institutional investors, particularly in electroni-cally traded futures contracts, with online order entry and execution. Whats more,mini products created specifically to appeal to individual investors are now stan-dard among exchange offerings.

This book reveals the many ways that individuals can use futures for tradingand portfolio diversification. Our aim is to remove the mystique about tradingfutures, clear up common misperceptions, and prepare individuals to begin usingfutures as a trading or investment tool in a responsible manner. The productsare highly leveraged and marked to the market daily. Thus, the industry is well-regulated and has superior financial safeguards in place to ensure trading integrity.

So, if you understand the risks and are able and willing to accept them, theres noreason you shouldnt take advantage of the benefits inherent in futures. As wepoint out many times throughout this book though, futures trading is not suitablefor all investors.

The first few chapters introduce you to the futures markets, explain their his-tory and purpose, and provide an overview of how individuals participate in themarkets. Specifically, youll learn about the choices you have in trading or invest-ing in futuresfrom working with a broker to investing in a professionally man-aged product or trading on your own. This will help you decide which path isright for you.

Later on, we introduce you to the myriad of futures products available totradefrom the Dow Jones Industrial Average to gold to soybeansand provide abrief background on the factors important to price movement in each market. Yetanother chapter delves into the way many traders use technical analysis as a deci-sion-making tool. In addition, youll learn about options on futures and cash for-eign exchange trading in two chapters devoted specifically to those topics.

Our book helps you understand the hows and whats involved in futures trad-ingincluding opening an account, types of orders, margins, tax treatment, andresolution of disputes.

The Complete Guide to Futures Trading is your futures trading handbook. Theprofessionals who have contributed to this effort bring decades of devotion and ex-perience in the futures industry to the subject matter. We challenge you to learnfrom their experience, and as a result, make an informed decision about whetherfutures are right for you and your investment portfolio. We sincerely hope that thisbook convinces you that there may be a place for futures in your investment play-book, and guides you in making appropriate decisions about how you trade.

A twenty-firstcentury investor needs to know about the investment of thetwenty-first century. That investor is you, and that investment is futures.

MARK B. SACHSPresidentRefco Private Client GroupJanuary 2005

xii PREFACE

xiii

About the Contributors

Carol Dannenhauer is Director of Managed accounts at Refco Private ClientGroup. Carol started her industry career in the late 1970s. She spent a number ofyears working for her brother on the floor of the Chicago Mercantile Exchange be-fore beginning her RefcoPCG tenure in 1986. She is responsible for RefcoPCGsManaged accounts division, which serves as the liaison between the client and thecommodity trading advisor community.

Phillip Fondren is Executive Vice President of Refco FX Associates, LLC. Philbegan his career as a bullion trader and shifted to foreign exchange in the early1980s when international money flows spurred a huge demand for investment ser-vices in foreign exchange. Since then, he has run foreign exchange trading andsales operations for several firms, having joined Refco in 1997.

Susan Abbott Gidel is Director of Marketing at Refco Private Client Group. Su-san began her career in the futures industry as an editor at Futures magazine, cov-ering the industrys developments during its explosive expansion into financialfutures, options, and stock indexes worldwide. She is also the author of Stock In-dex Futures & Options: The Ins and Outs of Trading Any Index, Anywhere(John Wiley & Sons, 1999).

Jim Gombas is Director of Refco Private Client Group Plus, RefcoPCGs broker-assisted division. Jim began his career with RefcoPCG on the floors of the ChicagoBoard of Trade and Chicago Mercantile Exchange in 1984. He received his licensein 1985 and moved into the Retail Sales division, which he then managed until1994, when he started up the RefcoPCG Plus division. Jims team of market strate-gists offers a myriad of services to clients who choose to have a futures profes-sional work with them as they trade.

Greg Gulotta is Vice President of Trade Center Operations at Refco PrivateClient Group. Greg started his futures career with RefcoPCG in the Trade Centerin 1985. In the ensuing years Greg assumed positions of increasing operational re-sponsibility and assumed the position of vice president in 2001.

David Howe is Sales Manager at Refco Private Client Group. Dave received his fu-tures license in 1987 and joined RefcoPCG as an account executive in 1988. Hewas promoted to his current position in 1999 after moving up through the rankswithin the sales department. His staff is the first point of contact for most in-vestors interested in establishing a relationship with RefcoPCG.

Herb Kral is Director of RefcoPCG Auto-execute services, the division withinRefcoPCG that caters to clients who want to trade using platforms or auto-executingprograms. Herb began his futures career in 1996 as a phone clerk on the tradingfloor of the Chicago Board of Trade and moved up to the position of complianceofficer. He joined RefcoPCG in 1998 and was promoted to his current positionshortly after.

Dan McMullin is the former Director of Business Development at RefcoPCG. Dan,who is now an independent trader, has more than 16 years of industry experience,having traded futures for his own account both on the exchange floor and from theback office. He was a principal of a small brokerage firm and has worked with and ad-vised hundreds of professional and retail investors. Dan devoted a significant amountof his time to developing and delivering educational programming to investors.

Laura Oatney is Content Manager in the Marketing Department at Refco PrivateClient Group. Laura began her futures industry association at the Chicago Boardof Trade in the late 1970s. In 1982, she moved to the then-fledgling National Fu-tures Association, the industrywide self-regulatory organization for the futures in-dustry, where she served ultimately as Director of Communication and Education.She joined RefcoPCG in 2002.

Mark Sachs is President of Refco Private Client Group. Mark has spent almosttwo decades in the futures industry, 16 years of which have involved increasinglevels of operational responsibility within RefcoPCG. He started with RefcoPCG in1986 as an account executive. In the early 1990s, he was responsible for openingand managing RefcoPCGs London and Hong Kong offices. When he returned tothe States, he managed both the firms corporate relationships and its 24-hourglobal trade operations. In 2002, he was promoted to the position of president. Hecurrently serves on various committees for the Futures Industry Association andon the Chicago Board of Trades Futures Commission Merchant Committee.

Philip Silverman is Vice President and Secretary of Refco, LLC. Phil is a licensedCPA in the state of New York. Phil has been in the brokerage business since 1981,and began his association with Refco in 1986.

Nancy Westwick is an Associate General Counsel of Refco, LLC. Nancy joinedRefcoPCG as its assistant general counsel in 2000. Prior to that she worked forvarious equity option traders and security brokerage firms for almost two decades.

xiv ABOUT THE CONTRIBUTORS


Futures Trading

1

C H A P T E R 1

FuturesThe Investment for theTwenty-First Century

Mark Sachs

Investors have many choices today for investing their money. The first onethat often comes to mind is the stock market. It has been estimated that morethan 50 million U.S. citizens have some stake in the performance of the stockmarket, either through investments in individual stocks or mutual funds or viaparticipation in 401(k) or other company plans, individual retirement accounts,government pension plans, or some other program that gives Main Street resi-dents a piece of Wall Street action.

Then there are the bank certificates of deposit and numerous types of bondsthat have long been familiar investment vehiclespassive instruments that arebased on interest rates and dont require much attention.

So you may be wondering why you should be interested in a more active trad-ing style featuring futures, options on futures, or cash foreign exchange markets,traditionally perceived as more risky places to put your money.

Futures markets have benefits that the stock market simply cant provide, andtraders are just beginning to discover what brilliant tools they are for participatingin a wide variety of markets. Long known, used, and understood by producers andusers of commodities such as grain, gold, and crude oil, futures markets today alsoencompass such financial products as stocks, stock indexes, and interest rates.Whats more, futures markets are not just a U.S. phenomenonthey exist theworld over, on every continent but Antarctica. Just take a look at Appendix A, Do-mestic and International Futures Contract Volume, and youll see how diverse theproduct offerings are and how global todays marketplace really is.

When it gets right down to it, futures arent hard to understand. In fact, theyare fairly straightforward. Like stocks, buy low, sell high is the basic premise.Whats different is that you can trade futures with leverage, and on either a longor a short position. That introduces an additional element of risk not present in

the stock market. Another significant difference is that there is no uptick rule infutures. Thus, it is just as easy to sell short as it is to buy, thus easing entry into aposition to capture a downward move in prices.

HISTORICAL ROOTS

Some people say that the concept of futures trading began in China nearly 1,400years ago and that it was also used in the Japanese rice market centuries ago. Butfutures trading as U.S. traders know it today has its roots in the mid-1800s when itall started in Chicago, the city that works.

Mother Nature blessed Chicago with a location that lent itself to becoming acenter of commerceat the south end of Lake Michigan and at the mouth of ariver system that reached all the way to the Gulf of Mexico. From Chicago, distrib-utors and suppliers could reach the East Coast via the Great Lakes and the mid-section of the country by river. This location in the middle of the United Statesalso helped Chicago become a railroad hub.

This was good news for producers and users of commodities, such as wheatand corn. Farmers brought their harvest to Chicago to sell it to the companies thatwould turn it into bread and other foodstuffs. Chicago provided one central loca-tion for buying and selling. It was a great idea but still needed improvement.

At harvest time, the supply of grain overwhelmed the demand, so prices werelow. Months later, prices would rise as supplies dwindled. Farmers wanted a wayto cash in on the higher prices. Users wanted a way to ensure steady supplies aswell as smooth out and better predict how much their raw ingredients would cost.So they started making deals that established the price of grain for a delivery datein the future.

But there still was the matter of what we call today counterparty risk. TheChicago Board of Trade (CBOT), founded in 1848, solved the problem by creatingstandardized contracts for the future sale of grain. The contracts were inter-changeable, so the buyer or seller of a contract could get out of the obligationwithout any harm to the original counterparty. In the 1920s, the CBOT added aclearinghouse to become the ultimate counterparty to everyone who trades a fu-tures contract. To date, this clearinghouse system has never had a default.

Economic necessity gave birth to futures markets. And good old American in-genuity has kept redefining the futures markets ever since.

WHAT FUTURES ARE

A futures contract is an obligation to buy or sell an underlying product at a spe-cific price at a specific time in the future. Well explain each key phrase in thatsentence, so you can understand the elements that define a futures contract.

2 THE COMPLETE GUIDE TO FUTURES TRADING

Obligation to Buy or Sell

The key word is obligation. Unless you offset your original position before thecontract expiresand nearly 100 percent of speculators do just thatyou musteventually buy or sell at the agreed-upon price when the contract expires. Hereis a brief explanation of how buying and offsetting a position might work with anE-mini Standard & Poors 500 stock index futures contract. All futures contractsfollow this same scenario, differing only in the total contract size and value ofthe contract.

Long Position Example You buy a June E-mini S&P 500 index futures con-tract when it is trading at 1000. The contract size is $50 times the index level, soyour position equals a $50,000 ($50 1000) stake in the S&P 500 index. If the indexgoes up 10 points before the futures contract expires, you would receive $500, lesscommission and fees.

If the index declines 10 points to 990, the value of the contract drops to$49,500. Unless you offset your position by selling a June E-mini futures contractbefore it expires in the third week of June, you will be obligated to pay the differ-ence in contract value of the price at which you bought versus the final expirationprice to fulfill your side of the deal. This cash payment occurs because the E-miniS&P 500 is cash-settled. In futures contracts that require physical delivery, youwould be required to buy the underlying product. (Most futures positions are off-set before expiration, however.)

Short Position Example You sell a June E-mini S&P 500 futures contractwhen it is trading at 1000. Just as when buying to initiate a position, the contractsize is $50 times the index level, so your position equals a $50,000 ($50 1000)stake in the S&P 500 index. If the index rises 10 points to 1010 when the futurescontract expires, the value of the contract increases to $50,500.

Unlike shorting in stocks, the next part in futures trading is just like the longposition example. Unless you offset your position by buying a June E-mini contractbefore it expires, you will be obligated to pay the difference in contract value of theprice at which you sold versus the final expiration price to fulfill your side of thedeal. Once again, this cash payment occurs because the E-mini S&P 500 is cash-settled. In futures contracts that require physical delivery, the seller is required tosupply the underlying product to a buyer to fulfill the contract obligation if the posi-tion is not offset. (But you dont have to worry about that with stock index futures.)

If you sell and the index declines by 10 points, you would receive the $500,less commission and fees.

Underlying Product

Futures contracts originally were created for agricultural products such as cornand cotton. In the 1970s and 1980s, futures contracts on financial instruments such

Futures: The Investment for the Twenty-First Century 3

as U.S. Treasury bonds and stock indexes became popular. Futures contracts onindividual stocks, called single-stock futures, are the latest innovation in this fi-nancial arena.

Each futures contract specifies a certain amount (and sometimes quality) ofthe underlying product, so that the contract terms are standardized for all partici-pants. For example, one E-mini S&P 500 futures contract represents exposure toall 500 stocks in the S&P 500 index. Contract standardization means that investorsdont have to worry about anything but the business at handchanges in price.

Specific Price

Futures contracts are traded in public, government-regulated forumsexchangeswhere business is conducted either electronically or in traditional open-outcrypits on a trading floor. Prices are determined by the orders that come into themarket from buyers and sellers. When an order from a buyer at $100 meets an or-der from a seller at $100, a trade occurs and a futures price of $100 is broadcast tothe world.

Specific Time in the Future

Futures contracts expire at a certain time in the future. For example, a December2005 futures contract will cease to exist sometime during the month of Decemberin 2005 (depending on rules set by the exchange). Specifically, E-mini S&P 500 fu-tures expire on the morning of the third Friday of March, June, September, and De-cember. As with other elements of the contract, a standardized expiration datemakes it easier for investors to focus on pricing decisions.

WHAT FUTURES ARE NOT

Now that you have been introduced to what futures contracts are, lets explorehow they differ from other financial instruments you may be more familiar with,like stocks, options, and exchange-traded funds.

Futures Are Not Stocks

It may be too obvious to say that futures are not stocks, but it is essential to un-derstand the important differences between these two investment vehicles, sum-marized in Table 1.1.

Agreements, Not Ownership A futures contract is an obligation to buy orsell at some time in the future, at a price agreed upon today. A futures contractdoes not convey ownership, as buying a share of stock does; it is only the promise


TAB

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5

that a buyer and seller will agree to exchange ownership in the future. Like stocks,futures contracts are usually traded on an organized and regulated exchange sothe buyers and sellers can find each other easily. Because futures contracts arestandardized and interchangeable, they can be traded anonymously among peopleon an exchange, where all that remains to be negotiated is the price.

All futures contracts are settled daily (assigned a final value price). Based onthis settlement price, the values of all positions are marked to the market each dayafter the official close. Your account is then either debited or credited based onhow well your positions fared in that days trading session. In other words, as longas your positions remain open, cash will either come into your account or leaveyour account based on the change in the settlement price from day to day.

This system gives futures trading a rock-solid reputation for creditworthinessbecause losses are not allowed to accumulate without some response being re-quired. It is this mechanism that brings integrity to the marketplace. Or, consid-ered another way, every trader can have confidence knowing that the other side ofthe trade will be made good. In fact, the clearing member firmsand, ultimately,the exchanges themselvesguarantee that each trade will be honored (see Chap-ter 14). So, as a trader, you never need to give any thought to the reliability of theperson on the other side of your trade.

Contracts, Not Shares The supply of futures contracts is unlimited. A newfutures contract is created every time a buyer and seller make a trade. Unlikeshares of stock, there is no limit to the supply of futures contracts. Every time abuyer and seller make a trade, a new contract is created.

Because a futures contract is an obligation to buy or sell at a certain price at acertain future date, theres no getting around the fact that the obligation must befulfilled. In most cases, the obligation is fulfilled by simply making an offsettingtrade (sell if you bought; buy if you sold). Of course, you can choose to carry theposition all the way to the delivery date, when it is fulfilled either by the exchangeof the physical commodity or by a cash settlement to or from your trading ac-count; but again, that is almost never the case for the speculator. That possibilityhelps to keep futures prices closely aligned to cash prices.

Contract Expirations, Not Perpetual Assets Because futures contractsexpire on a specific date in the future, a settlement between the buyer and theseller means the contract ceases to exist after that date. Shares of stocks, on theother hand, continue to exist (unless a company dissolves or a stock buyback orsome other development reduces the number of shares).

Because of these contract expirations, futures traders sometimes will main-tain a position by rolling from one contract month to the next, taking into consid-eration the trading liquidity available. Say you have a long position in the MarchE-mini S&P 500 contract, and it is the first week of March with just three weeksuntil the contract expires. If you want to maintain that position, you would roll


into the June contract by selling your March contract and simultaneously buyingthe June contract. Your brokerage firm could assist with that process.

Good-Faith Deposit, Not a Down Payment The word margin meanssomething different in futures than it does in stocks. In stocks it means that youreborrowing money and paying interest. In futures it simply refers to the amount ofmoney that you need to have in your account to enter a transaction.

The margin required for a futures contract is better described as a perfor-mance bond or good-faith money. The levels are set by the exchanges based onvolatility (market conditions) and can be changed at any time. The Federal Re-serve sets the margin level for stocks and has maintained a 50 percent minimumrequired for leveraged stock trades for many years.

Generally, futures margins are much less than the 50 percent required forstocks. The performance bond (margin) requirements for most futures contractsrange from 2 percent to 15 percent of the value of the contract with a majority inthe 5 percent area. A brokerage firm may establish or change its own performancebond requirements at any time.

Of course, futures margins refer to the exchanges minimum required balancesto place a trade. A trader is certainly free to maintain a much higher balance, oreven the full contract value (100 percent).

Leveraged, Not Paid For in Full Leverage is what futures markets are allabout. As a futures trader, you can access the full value of a futures contract for arelatively small amount of capital, typically 2 percent to 15 percent of the con-tracts value. For example, for about $3,500 in margin, you can buy or sell an E-mini S&P 500 futures contract covering stocks worth $50,000.

Because futures markets are highly leveraged, the effect of price changes ismagnified. With stocks, you typically pay the price in full (i.e., without leverage) oron margin (50 percent leverage). If you speculate in futures and the market movesin your favor, leverage can produce large profits in relation to the amount of yourinitial margin. However, if the market moves against your position, you also couldlose your initial margin and then some.

For example, assume that youve decided to put $10,000 into a futures ac-count. You buy one E-mini S&P 500 index futures contract when the index is trad-ing at 1000. Your initial margin requirement for that one contract is $3,500.Because the value of the futures contract is $50 times the index, each one-pointchange in the index represents a $50 gain or loss.

If the index increases 5 percent, to 1050 from 1000, you could realize a profitof $2,500 (50 points $50). Conversely, a 50-point decline would produce a $2,500loss. The $2,500 increase represents a 25 percent return on your initial investmentof $10,000 or a 71 percent return on your initial margin deposit of $3,500. Con-versely, a decline would eat up 25 percent of your original $10,000 or 71 percent ofyour initial margin. In either case, an increase or decrease of only 5 percent in the


index could result in a substantial gain or loss in your account. Thats the power ofleverage.

Leverage can be a beautiful thing. When everythings going your way, it makesyour money work harder and produce more in a shorter period of time than if youpaid for everything in full, up front. Indeed, leverage is the key, distinctive aspectof futures trading as compared with stock trading.

But there is a dark side to leverage, too. For example, assume you use $5,000in your account to buy an E-mini S&P 500 contract worth $50,000. Instead of goingup, however, prices fall by 10 percent and the contracts value drops to $45,000.Your $5,000 is completely gone. Unless you get out of the position with an offset-ting sale when your maintenance margin level is violated, youll be obligated to putup even more money if the market keeps moving against you. Leverage is the oneingredient that can produce either horror stories or happy endings. To get thehappy ending, it is extremely important that you fully understand the power ofleverage and how to manage it well.

Futures Are Not Options

You might think that futures and options are similar, if not identical. But, in fact,the only thing that looks similar about the two instruments is that they both havean expiration date. Despite its expiration, a futures contract is not a wasting assetlike an options contract.

An options contract conveys the rightnot the obligation, like a futures con-tractfor a buyer to assume a position in the underlying instrument at a specific(strike) price at any time before the option expires. When you buy (go long) an op-tion, your risk is limited to the amount you pay for this right. The cost of the op-tion is known as a premium and is based on time, volatility, and the relative valueof your strike price to the underlying market.

Futures Always Have Intrinsic Value A futures contract always has value,calculated by multiplying the current price by the contract unit sizeunless theprice is zero, of course. Meanwhile, an options contract is a wasting asset, and itsvalue could decline to zero on the expiration date (unless it is in-the-money). Ifyou paid for the right to purchase stock at $50 before the third Friday in June andthe stock is trading at $45 on that third Friday, you will not benefit from all themoney you paid for that call option as it expires worthless.

Futures Are a Straight, Market-Direction Play You have to ask only onequestion before making a futures trade: Buy or sell? The futures price is going togo either up or down from todays price (or stay the same) by the time the contractexpires. All you have to decide is which way you think its going to move.

You have more decisions to make with options. Besides having to decidewhether to buy or sell, you have to decide whether to buy or sell a put or a call.Then you still have to consider strike price, time to expiration, volatility, and


whether the premium is rich or cheap. And thats not even mentioning alpha, beta,delta, gamma, vega, or other factors that determine an options price.

Futures Always Have Unlimited Risk The value of a futures contract is ulti-mately tied to the underlying product or instrumentthe S&P 500 index, gold,crude oil, soybeans, T-bondsvia each contracts specifications. You can eitherbuy (go long) or sell (go short) any futures contract, and your risk (or potentialprofit) is virtually unlimited.

If you purchase a call or put option, you have a clearly defined risk (the pre-mium you paid). However, if you sell (write) uncovered calls or puts, you are ex-posed to unlimited risk with options, just as you would be with futures.

Futures Are Not Exchange-Traded Funds

Exchange-traded funds (ETFs) were introduced in 1993 and have become popularinvestment products. ETFs now exist for nearly every major stock index and sec-tor index, allowing you to purchase a piece of an index just like you purchaseshares of individual stocks. Among the best-known ETFs are those on the S&P 500index (SPDRs or SPY), the Dow Jones Industrial Average (DIAmonds), and theNasdaq-100 index (QQQs).

Futures and ETFs do have some similarities. For example, they are a liquidmarket, you can use them to hedge a portfolio of stocks or mutual funds, theydont require an uptick to sell short, they can be used for efficient cash manage-ment, and they may not have heavy tax burdens if the securities are held long-term. In fact, futures offer even greater tax benefits because they are treated underthe 60/40 rule (60 percent of the gain from futures is taxed at long-term favorablerates and 40 percent as ordinary income; see Chapter 13 on taxes).

But because they are traded like stocks, ETFs do have some of the same dis-advantages as stocks when compared to stock index futures. The most significantis the 50 percent minimum margin requirement for ETFs instead of the low mar-gins required for stock index futures. In addition, many stock index futures aretraded electronically virtually 24 hours a day, whereas ETFs have limited tradinghours; and options are available on leading stock index futures but not on ETFs,giving futures traders more flexibility in establishing and managing positions.

WHO TRADES FUTURES?

Futures participants fall into two broad categories: speculators and hedgers. Ifyou trade for your own financial benefit, youre a speculator. If you trade futuresbecause you have some risk associated with the underlying commodity, youre ahedger. A basic understanding of each groupwho they are and what roles theyplay in the marketplacewill better prepare you to participate in futures markets.


Speculators

A speculators job is easily defined: Buy low, sell high. Or sell high, buy low.Make money. Speculators come in all shapes and sizes with all sorts of motiva-tions. As any futures exchange will tell you, speculators are the grease thatkeeps the market wheels turning. Even today, all futures markets exist becauseof the economic necessity of providing commercial entities a way to transferrisk, just as they did in the 1800s when grain producers and users needed to buyand sell in Chicago. But speculators play a vital role in the markets success.These speculators include:

Professional traders, whether trading on an exchange floor or off a computerscreen.

Investors like you, who see futures as a way to try to make money. Money managers who invest on behalf of their clients. Firms that trade with their own money as a business venture.

Big, small, individual, or corporate, all speculators try to capitalize on theiropinion of whether the market is going to go up or down. The diversity of opinionamong speculators, and their sheer number, provides the liquidity that hedgersneed to transfer their commercial risks to others. The more speculators there are,the more likely there will be someone who is willing to buy or sell at any particularmoment at any particular price.

For the most part, its safe to assume that individual speculators trade asmaller number of contracts than hedgers and hold market positions for a shortertime. Exchange rules and federal regulations limit the maximum number of con-tracts that can be held by any one speculator in any one market. In futures marketlingo, this restriction is known as spec limits.

Hedgers

Hedgers transfer cash market risk to the futures markets. Thus, making a futurestrading decision also involves a cash market decision. Like speculators, hedgerscan either buy or sell, depending on their situation.

For example, a cereal company that buys corn futures as a hedge has concludedthat cash corn prices will be higher when the company has to purchase corn to makecereal at a later date. When that later date arrives, the company offsets its hedge byselling futures and buys corn in the cash market. If cash prices did rise since the com-pany bought the futures contract, then it is likely that the increased value of the fu-tures contract will reduce the actual net cost of corn to the cereal company.

Conversely, a corn producer who sells corn futures as a hedge has decidedthat cash corn prices could be lower than todays price when it is time to sell thecrop. If the producer is right, the hedge likely will have provided a profit that canbe added to the revenues generated from selling corn in the cash market.


Although a hedge transfers price risk, it should also be noted that locking in aprice does deny the hedger the opportunity to gain from favorable price move-ments in the cash market.

MAKING YOUR CHOICE

The choice of which vehicle to use is obviously a matter of preference for each in-vestor. The active short-term trader will probably prefer the cheap transactioncosts and the efficient executions offered by futures. Some traders will use stocks,ETFs, or futures as complementary products and may also include options, espe-cially those who want to spread or arbitrage products.

When it comes to the bottom line, futures provide the most leverage and asimple, clear-cut view of a market: If prices are going up, buy; if prices are goingdown, sell.


13

C H A P T E R 2

Becoming aFutures Trader

Dan McMullin

Knowing about the markets and deciding to invest in them are big steps foran aspiring trader. But then you are faced with an even greater questionone that will help determine whether you meet your investing goals:How do I make a trading decision?This chapter presents an overview of some of the many techniques used to-

day to analyze futures markets so you can make sound trading decisions. Ofcourse, most of these techniques have entire volumes written about them, and adetailed discussion of each topic is beyond the scope of this chapter. Still, withthis chapter, you will gain a broad introduction to the meat and potatoes oftrading.

You may be surprised to find that this chapter will be useful to both the in-dependent trader and the investor who takes the less-involved route of man-aged futures or an auto-execute trading system. The independent trader whochooses either the self-directed or the broker-assisted trading approach willcertainly wish to know how to make trading decisions. Less obvious, though, isthe benefit to the managed or auto-execute investor, who can use the sameknowledge to help choose a program from among the universe of programsavailable for investment.

A basic rule for passive investors is: Know your managers investment philos-ophy. A recurring theme throughout this book is that, whichever approach to in-vesting you choose, it should be a good match to your personality and comfortlevel. This chapter will help you understand your choices from among the differ-ent styles and methods of analysis. So, whether your goal is to choose the rightprogram, to select the best broker, or to learn how to trade on your own, this chap-ter provides a solid foundation for your decision. Other chapters will go into amore thorough discussion about whether you should be trading on your own orwith the help of a broker, managed account, or auto-execute program.

Before getting into the nuts and bolts of forecasting prices, well review someissues important to making trading decisions.

TRADING DECISION ISSUES

Lets start with the obvious: For each one of the millions of trades placed everyday, there are both a buyer and a seller. Or, looked at another way, for every per-son willing to buy, another person is equally convinced it is time to sell.

Not surprisingly, youll find many opinions on the best way to make this trad-ing decision. One persons winning formula may go into a losing streak right whensomeone elses starts a winning period. Does that mean that one person is rightand the other is wrong? Not necessarily. The lesson may be that different strate-gies succeed at different timesand when applied to different investment timehorizons.

Perhaps its best to approach this chapter with the understanding that no sin-gle answer about how to make a trading decision is right for everyone. Differenttraders will have their own answer to the question posed at the beginning of thischapter. This is the very reason you need to explore the topic individually andchoose the methods that work best for you. In fact, did you know that many be-lieve the best trading decision is to not make one at all? Hmm, read on.

Random Walk and Efficient Markets Hypothesis

The academic community teaches that changes in price are serially indepen-dentin essence, random and unpredictable. According to the efficient marketshypothesis, the typical investor is unable to beat the market trading actively overtime and would actually be better off with a buy-and-hold strategy because of thelower transaction costs. The theory holds that, although financial assets have anintrinsic value, the actual price will fluctuate randomly around that value. Further,although the intrinsic value will change over time, the direction and extent are es-sentially unknowable. The marketplace itself is efficient in reflecting all knownfacts at any given moment.

Of course, traders dispute this theory. Their very existence is in contradictionto the idea that markets are perfectly efficient. Traders are dedicated to identifyingopportunities to profit from forecasts and mispricings, and they challenge the effi-cient markets hypothesis on nearly every front. First, they point out that the hy-pothesis is based on unrealistic assumptions about perfect dissemination of newsand events. In the real world, news can take hours, days, or weeks to be fully un-derstood and absorbed. Also, events can cause overreactions, and markets can re-act differently on different time frames to the same event. Finally, traders arguethat markets can have extended periods of both directional trends and choppy,sideways action, all of which can be exploited.


The point made here is that buy-and-hold is considered by some to be the besttrading decision of all. So you need to be aware of these two opposing viewpointsand decide for yourself whether you believe forecasting prices is worth the effort.You may conclude that being a passive investor is best for you.

This is yet another example of the importance of choosing for yourself the in-vestment style that best fits your personality and comfort level. In fact, some arguethat a mismatch between investment style and investor personality is the underly-ing root of most trading failures. The main thing to remember is that, if you dontbelieve in the analysis, you wont stick with it during the down times.

Now, academics aside, there is also a category of traders who believe thatforecasting the market is nonproductive. Is this a contradiction? Lets consider theargument.

Forecasting versus Reacting

Even among traders, some argue its best to not have an opinion at all about the di-rection of pricesthat its better instead to simply react to the market action.Such traders may watch for a trend reversal or a breakout and then jump inquickly in hopes of catching the move. Momentum trading, scalping, and swingtrading can be such methods.

But, of course, even a reactive trader is forecasting a price move based on theevents of the moment. The only difference is that the forecast is based on eventshappening in a very short time frame.

Regardless, your best method of making a trading decision may be to simply setyourself up for very speedy responses to fast-breaking events and price action. Manytrading arcades and software packages are in place to support just such a style.

So the expected time horizon of a trade turns out to be a significant factor inmaking a trading decision. Lets explore that concept a little further.

Consider Your Time Frame

Floor traders can tell you that both parties to a new trade can wind up losing orwinning on that trade; the trade doesnt necessarily have to be a win-lose situationfor those two traders. The reason, of course, is because each trader has a differenttime frame. The market may rally five minutes into the trade, and the trader whobought gets out with a quick profit. An hour later, the market may fall and thetrader who sold will have gotten out profitably as well. Likewise, both traderscould also lose on the trade.

The lesson is that your market forecast can look quite different for differenttime periods. Your final analysis should always keep this in mind. Consider twoother points about differences in time frames:

1. In general, shorter time frames will tend to have more random movement,often called noise. Some traders are able to make the noise work to their

Becoming a Futures Trader 15

advantage, while others would rather focus on the bigger trends. Still othersmay do well considering both the trees and the forest. As mentioned before,one of your tasks early on should be to determine which time frames you aremost comfortable trading.

2. Whichever time frame works best for you, you may find value in keeping aneye on other nearby time frames. A buzz phrase in recent years has been thethree-screen method of trading. This simply refers to a principle of drillingdown the market analysis from broad to specific, looking at weekly, daily, andhourly charts, for instance. Studying multiple time frames can give context tothe events in any particular time frame.

Subjective versus Objective

In addition to the time frame, central to the matter of making a trading decision isthe issue of art versus science. Different analysts will interpret the same informa-tion in different ways.

Weve all heard jokes about a roomful of economists not being able to agreeon a reading of certain statistics. So it is with traders. Crop reports and FederalReserve Board actions are subject to a wide range of interpretations. Chart read-ers may also see and trade the exact same patterns in very different ways. Again,this fact does not necessarily invalidate the usefulness of forecasting; instead, itpoints out the influence of individual subjectivity in analysis.

Figure 2.1 shows a basic channel pattern on a price chart. How might differenttrading styles approach that same pattern?

Momentum traders might buy on strength near each new high and suffer a se-ries of small losses until the final actual breakout to new highs.

Range traders, on the other hand, will do just the opposite, selling on rallies tothe upper band because they expect the channel to remain intact.

Breakout traders will buy as the market moves above the channel (or aboveprevious highs), betting an upward move is about to begin.

Others will count waves within the channel in an attempt to predict when themarket will switch from channel to breakout.

Trend followers who bought earlier may remain long the entire time with anexit stop placed below the channel.

Is one method better than another? The most that can be said may be that dif-ferent methods work best at different times.

You shouldnt be too surprised at the abundance of viewpoints on how tomake a trading decision. After all, the wealth of opinions as to the best course ofaction is what makes a market. To get around this subjectiveness, certain traders,called systems traders, quantify the buy/sell rules and back-test the results. Theyseek an objective set of rules that profit over time. (See Chapter 5 for more detailson systems trading.)


While the methods for making a trading decision can be labeled in manywayssystems trading, volatility trading, swing trading, range tradingthe under-lying analysis typically falls into the category of either fundamental analysis ortechnical analysis.

Fundamental Analysis versus Technical Analysis

The classic description of fundamental analysis is that it examines the supply anddemand factors influencing a markets price. But those factors differ wildly frommarket to market. You know this intuitively: The factors affecting sugar are quitedifferent from those affecting wheat, crude oil, Swiss francs, or gold. So, as a prac-tical matter, the fundamental trader becomes an expert in a particular market. Forthis reason, fundamental analysis is sometimes considered to be old-school, per-haps because the most learned experts on a given market are those who havestudied it the longest.

Weather is considered a fundamental event and plays an important role, evenin markets you may not suspect would be influenced by weather. For instance, bad


FIGURE 2.1 Price channel. Different traders approach the same data in different ways.(Source: eSignal, www.esignal.com)

weather can depress consumer spending, and in turn, corporate earnings andstock index prices. Some traders become mini-experts in the severity and timingof weather events affecting their chosen markets.

Like weather, other dominant macro fundamentals can affect multiple mar-ketsfor example, economic conditions may dampen overall demand, or thevalue of the dollar may influence the pricing of unrelated markets. For the mostpart, however, fundamental analysis is concerned with the news and eventsunique to each market.

In contrast, technical analysis is the study of price action, with no regard givento the news and events that lead to that movement. The idea is that the best inter-pretation of underlying news is already reflected in the price. Unlike fundamentalanalysis, charting techniques can be applied across many different markets andtend to be more widely used by traders. Even fundamental traders will often con-sider the technicals to determine the timing of their trades.

So dont worry about choosing the right label to assign to your work; youmight find you have a knack for interpreting certain macro events (fundamen-tal) and use that skill to provide a context for your chart reading and indicators(technical).

Some traders find themselves drawn to a market because they started with anunderstanding of the fundamentals for that particular market. For instance, some-one who enjoyed tracking the stock indexes on the nightly news can most easilybegin investing in those markets. That same trader may not have the same initialcomfort level with agricultural markets or even other financial markets such as in-terest rates or currencies. Although its true that different markets can exhibitunique sets of characteristics, your decision about which markets to follow is apersonal one and will dictate which reports you watch and what style of tradingyou implement.

The remainder of this chapter introduces you to some of the general conceptsof these two categories of analysis and explores a little more deeply the most im-portant elements of each.

FUNDAMENTAL ANALYSIS HIGHLIGHTS

Fundamental analysts examine a variety of reports to evaluate changes in demandfor a product or availability of that product to the marketplace. With experience,an analyst can develop strong instincts on how price will respond to variouschanges in the minutiae of supply and demand.

Although the effects of supply/demand may seem less evident in markets suchas financials, they are the foundation of pricing for most physical commodities, es-pecially in the agricultural markets where the supply is renewable each year andwhere limits exist as to how long the products can be stored.

Supply is rather straightforward, although it can be subject to frequent revi-


sions. It is the quantity of a commodity available calculated by combining thestocks carried over from one season (or one week/month) to the next with newproduction and, in some cases, imports from overseas.

Demand is generally more difficult to quantify. In fact, the term used to indi-cate demand really should be usage or consumption. Demand may be greater orless than actual consumption. To complicate the matter, demand depends onprice: How badly do consumers or the marketplace want the available quantity ofthis product at this price? Demand for some commodities, like in the energy mar-kets, may not respond much to price increases. Demand for other products, likelivestock feed grains, may be very sensitive to price increases because they com-pete against alternative substitutes.

In simple terms, price is determined by a general formula: What is producedthis year, plus carryover stocks from last year, is compared against what is neededthis year. Plug in the various supply and demand data to solve for the variable ofprice. The idea is simple in concept, but difficult in real-world practice.

Traders rely on a number of government, corporate, and private events and re-ports to get a reading on the key factors that influence prices. Some of the reportsare considered to be leading indicators, some coincidental indicators, and somelagging indicators, depending on the data inputs necessary to calculate them andhow they relate to current conditions. For instance, the U.S. employment report,which includes numbers of new jobs, unemployment rate, wage rates, and so on,is generally considered a lagging indicator; in fact, jobs tend to be one of the lastareas of the economy to recover after a recession.

Several important facts need to be remembered about many of the reports:

The numbers cited typically are estimates based on surveys or other means ofgathering data that have been used historically but may not be absolutely cor-rect. However, they are usually the best numbers the market has to work with,so traders have to be aware of them.

Expectations for what the estimates should be are often as important as theestimates themselves. Markets tend to build in numbers that are widely per-ceived to be correct, so what may seem to be a bullish figure vis--vis a previ-ous time period may already be priced into the market. Only a surprise maymove the market to any large degree.

Futures markets anticipate. Todays prices may have already taken into ac-count tomorrows conditions. Buy the rumor, sell the fact is a market axiomthat describes how prices may react to confirmation of data in a report. Or youmay be totally correct in your analysis, but premature with your positions be-cause other traders havent caught up to the facts yet.

Market conditions change. What is bearish today may be bullish tomorrow, soyou always have to relate reports to the current investment situation.

Over the years, especially with economic reports, different events can takecenter stage for investors. Sometimes its inflation, while other times its in-terest rates, money supply, gross domestic product (GDP), or retail sales.


Recently investors were preoccupied with unemployment, jobless claims,and the price of crude oil. Now it seems the trade deficit and weakeningU.S. dollar are of greatest concern.

Futures traders must always be prepared for eventsthose social, political,weather, and other surprises that can sabotage the best of conclusions of fun-damental analysis.

The following pages provide descriptions of just some of the major newsevents and reports watched by fundamental traders, categorized by market. Thesereports deal primarily with U.S. markets, but many countries have equivalent re-ports for their markets. In addition, the exchanges sometimes offer extensivebackground resources for their respective products or links to web sites whereyou can find more detailed information.

Financials

Stock indexes, interest rates, and currencies are most influenced by reports thathave to do with aspects of the economy and with each otherfor example, whathappens to interest rates may have a major effect on the outlook for the U.S. stockmarket or for the U.S. dollar. A report that is positive for one market may be nega-tive for another. Economic reports also have a bearing on prices of some physicalcommodities, notably metals and energy. Here are some major reports that finan-cial traders watch.

Consumer Confidence Markets are really just a reflection of mass psychol-ogy, so anything that provides clues about investor sentiment can be a good indi-cator of price direction. The Conference Board, University of Michigan, and otherssurvey consumers regularly and release reports on their attitudes. These readingsmay suggest how much money will be spent by consumers, who account for alarge share of the economy, or how likely they will be to invest in the stock marketor housing.

Retail Sales Comparison figures tell economists and traders how well con-sumers are doing and how the current situation relates to previous periods.

Gross Domestic Product This is the broadest measure of all economic activ-ity in a nation and indicates overall economic growthor lack of it. How vibrantthe economy is will have an effect on almost all markets.

ISM Index The Institute of Supply Management (ISM) report indicates the statusof manufacturing conditions. What happens in manufacturing has a major bearingon employment, demand for raw materials, and the like, so economists analyze thisreport and some of its components carefully for clues about future growth.


Factory Orders The amount of orders pending is a good gauge of how activethe economy is and how it might fare in the future. Similar reports about durablegoods orders, industrial production, capacity utilization, business inventories, andothers measure what is happening in the manufacturing sector and, in turn, whatmay happen to the job market and other areas.

Employment Situation Nothing provides a better indication of how muchconsumers might purchase and how strong the economy is than how many peopleare working or how many people are unemployed. Monthly employment reportshave become a significant market mover in recent years as the economy adjusts totrends in outsourcing and downsizing.

Consumer Price Index, Producer Price Index These indexes measureprice levels of various goods and services and generally are considered to be thebest gauges of the inflation rate, which often has a bearing on interest rates. Ana-lysts examine components of these reports to see how current levels comparewith previous levels.

Housing Starts, Home Sales Housing is a major factor in the economy,with the level of activity indicating how much money consumers have to spendand how much demand there will be for raw materials such as lumber or copper,appliances, and all the other items needed for building and maintaining a home.Another related report on construction spending provides similar informationabout building offices, shopping malls, and so forth. All of these statistics reflecthow people feel about the economy and its future and may have an influence oninterest rates.

Balance of Payments Reports in this area deal with the level of a nations im-ports versus exports, commonly known as a trade deficit in the United States, andcash flows among nations. International trade figures provide a measure of eco-nomic conditions, and current account figures show how much money is movingfrom one country to another for investment purposes.

Federal Open Market Committee Meetings and Fed Actions Anythingthe Federal Reserve Board does or even hints at doing is closely monitored bytraders because of the effect on short-term interest rates and the U.S. dollar andthe possible repercussions on other markets and the economy. The Fed, whichmeets about every six weeks, attempts to walk a tightrope between stimulatingand tightening spending by adjusting short-term interest rates and reserve lendingrequirements in an effort to maintain a stable economy. Fed meeting days can pro-duce some volatile market movements.


Agricultural Commodities

The U.S. Department of Agriculture (USDA) provides a number of reports on com-modities produced in the United States as well as crops grown elsewhere in theworld. These reports on grains, soybeans, cotton, orange juice, and meats canhave a significant impact on the futures market prices for these commodities.

Many of these reports affect all of these markets in a ripple effectfor exam-ple, the amount of grain produced or in storage will have a bearing on feed pricesthat, in turn, may affect how many animals are raised and prices at the meatcounter. Others cover only selected areas. Because of the seasonal nature of pro-duction and consumption, a report in one month may have a much bigger impactthan the same report in another month.

Most of the major reports are so-called lockup reportsthat is, they are com-piled in a locked room and released to the whole world at the same instant. Thatmeans individual traders can have access to the information at the same time asthe largest trader.

For a calendar of when these reports are scheduled to be released, go to theUSDAs National Agriculture Statistical Service web site at www.usda.gov/nass/pubs/rptscal.htm or to the sites of other USDA agencies such as the Economic Re-search Service or the Foreign Agricultural Service. The USDA releases many otherstatistics and reports, but the following have the most impact on futures markets.

Crop Production Not all crops are covered in each of these monthly reports,but these updates of production estimates released about the 10th of each monthoften set the tone of the market for the month ahead. Some reports are only pro-jections, but other reports during the growing and harvesting season provide sur-vey-based estimates of yields and the size of the U.S. crop.

Prospective Plantings, Acreage These reports on spring-planted cropsindicate the acreage that farmers intend to plant (released at the end of March)and what they actually planted (released at the end of June). The June figuresmay be adjusted as officials get a better idea of the weathers effect on planting,but they often serve as the base from which crop sizes are estimated during theupcoming season.

Supply/Demand Estimates USDA officials release revised figures based onthe latest crop production report and other information each month, not only forU.S. crops but also for all other major crop-producing countries around the world,such as Brazil, Canada, Australia, and Europe. Total supply takes into account car-ryover from the previous season, new estimated production, and imports. Totaldemand is actually the expected consumption, either domestically for food, feed,or fuel or for exports. The remainder left over from supply minus usage is the newending stocks or carryover figure. A key number that traders watch is the endingstocks-to-usage ratio to see how it compares with previous years.


Stocks in All Positions In addition to the year-end stocks figures, the USDAalso announces estimates for the amount of stocks on farms and off farms eachquarter. This provides an important measure of usage as the season progresses.Based on its surveys of stocks available, the USDA sometimes revises its produc-tion estimates long after the regular monthly reports have been released.

Crop Progress, Crop Summary These are important weekly reports that up-date the condition of crops at the end of the previous week. During the plantingseason, these reports indicate how much of the crop has been planted, how muchhas emerged, and so on. Similar figures on the amount of the crop harvested arereleased during the harvesting season. The amount of the crop rated excellent,good, fair, and poor in each area of the major production regions during the grow-ing season helps traders calculate what the outlook for the size of yields and pro-duction may be.

Hogs and Pigs These quarterly reports (end of March, June, September, De-cember) provide estimates of hog numbers by weight category, farrowing inten-tions, pigs per litterin short, all the information traders need to calculate theamount and timing of pork production. Because production plans may change asprice or weather changes, actual slaughter figures may result in revisions to origi-nal numbers that surprise traders and cause volatile price action.

Cattle on Feed These monthly reports provide estimates of the number of cat-tle in feedlots by weight category in the major production states. They do notcover all cattle slaughtered, but just those in states that serve as a bellwether forthe cattle futures market. Annual and semiannual summaries of all cattle numbersbreak down the U.S. herd by type (dairy or beef), breeding herd, calf crop, andother categories.

Cold Storage Monthly cold storage reports indicate how many pounds of thevarious meats are in freezers. Although most meat moves into consumer handswithout going into storage, this report is important for a market such as porkbelly futures.

Softs or Exotics

Although still agricultural, commodities such as sugar, cocoa, and coffee are pro-duced primarily in countries with warmer climates, and the United States and Eu-rope are major importers of these commodities. The Foreign Agricultural Serviceof the USDA at www.fas.usda.gov does compile statistics and releases regular re-ports on these markets, which are traded at the New York Board of Trade and inLondon at Euronext.liffe.

These commodities all have prominent international organizations made up ofboth producing and consuming nations, and all have headquarters in London. In


addition to weather, which is always a key in commodity production, prices ofthese commodities tend to be more susceptible to social, political, and labor is-sues that may disrupt the flow of supplies. Traders need to especially monitorthese issues in the major producing and exporting countries:

Sugar is produced in many areas from either sugar cane or sugar beets, makingfor a competitive world market sometimes protected by tariffs or import quotas.Brazil is a major exporter. For more information on sugar, see the InternationalSugar Organization web site at www.sugaronline.com/iso.

Cocoa production is dominated by Cte dIvoire (Ivory Coast), Ghana, and In-donesia. For more information on cocoa, see the International Cocoa Organizationweb site at www.icco.org.

The worlds largest exporters of coffee are Brazil, Vietnam, Indonesia, andColombia. For more details on coffee, see the web site of the International CoffeeOrganization at www.ico.org.

Energy

The primary energy markets are crude oil and natural gas; the product markets areheating oil, unleaded gasoline, and propane. Futures contracts for all of thesemarkets are traded at the New York Mercantile Exchange and at the InternationalPetroleum Exchange in London, which both offer a number of information re-sources. Of the various grades of crude oil produced around the world, the leadersin futures trading are West Texas intermediate, which is traded in New York, andBrent crude, which is traded in London and Dublin.

On the supply side, the dominant force in world energy markets is the Organi-zation of Petroleum Exporting Countries (OPEC). On the demand side, trends ineconomic growth prospects have a major bearing on how much oil the worldneeds. OPEC attempts to set quotas for production that are low enough to main-tain prices it deems adequate but not so low as to stifle global economies and,therefore, diminish future oil demand.

In trying to maintain this tight supply/demand balance, energy markets are themost sensitive commodity market when it comes to political, labor, social, and eco-nomic issues, particularly in key production areas where supply disruptions may befelt almost immediately by importing countries. For this reason, weekly statistics ofU.S. stocks of crude oil and products provided by the American Petroleum Instituteat www.api-ec.api.org and the Energy Information Agency of the Department of En-ergy at www.eia.doe.gov often are market events driving energy prices.

In addition to economic conditions, extreme weather is a major factor for nat-ural gas prices. Because natural gas cannot easily be imported from overseas orstored, most of the supply moves via pipeline from the well to the consumer. Ifproduction is disrupted on the Gulf Coast during the hurricane season, or if unusu-ally cold or hot weather increases demand for heating and air-conditioning, nat-ural gas prices are likely to spike higher and then come down almost as fast whenthe situation passes.


Metals

Prices for precious metals such as gold and platinum have less of a supply/demand impact than most commodities. Instead, prices tend to respond to thevalue of the U.S. dollar, prospects for inflation or deflation, geopolitical ten-sions, or other situations where investors turn to metals as a store of value inuncertain times. Gold prices have been affected at times by central bank sales,but the latest political developments may provide a better gauge of prices thanany supply/demand issue.

By contrast, copper, palladium, and silver are nonprecious or industrial metalsthat do respond to supply/demand factorssilver has a dual role among the met-als for both its industrial and monetary uses. Copper, in fact, has been called themetal with a Ph.D. in world economics because its price is so sensitive to globaleconomic conditions that play a big role in demand. Any report that deals witheconomic conditions, especially those related to housing, automobiles, appli-ances, and the like, may have an effect on prices for these metals. Silver is alsosensitive to developments in photography.

All of these metals are traded on the COMEX division of the New York Mer-cantile Exchange and at several other exchanges around the world. Gold andsilver contracts were recently listed on electronically traded markets at theChicago Board of Trade. In addition to the exchanges, you can get informationabout metals from the International Wrought Copper Council at www.coppercouncil.org, the World Gold Council at www.gold.org, or the Silver Institute atwww.silverinstitute.org.

With this introduction to fundamental analysis behind us, lets now considerthe other major approach to analyzing marketstechnical analysis.

TECHNICAL ANALYSIS HIGHLIGHTS

Some call it voodoo, but its hard to argue with the widespread acceptance of tech-nical analysis in the investment community. Technical analysis is the study of priceaction but also includes a number of statistical indicators, as well as data on vol-ume, open interest, and other factors that relate to tracking prices.

Technical analysis is considered to be both an art and a science. This chapterwill focus more on the science part of the story and will leave the art side for youto ponder from your own experiences.

Charts of All Types

First and foremost, technical analysis means charts, and traders use several differ-ent types of charts, each providing a different view of prices. Which chart type andwhich technical indicators you use often depends on a look and feel to which youhave become accustomed. Whatever you use, your chart should help you get some


understanding of the markets price history and how past price action may provideclues about how prices may unfold in the future.

The following charts all cover about a four-month period of gold futuresprices. Note the information conveyed by each and see which type of chart is mosthelpful to you.

Line Charts Well start first with the line chart, not because it is the most popu-lar but simply because it provides the easiest explanation of basic chart construc-tion. Figure 2.2 shows a basic line chart constructed by connecting just the closingprices for periods without regard to other values for those periods, such as highsor lows. As with any chart, the periods viewed could be daily, weekly, monthly, orany intraday period such as 60 minutes or 5 minutes.

Media frequently used line charts in past years to present price action, perhapsbecause of their simple and uncluttered format. Line charts are still used today forpresenting single-value data, such as government statistics or supply/demand val-ues. However, with the proliferation of charting software, most traders have come


FIGURE 2.2 Line chart. The closing value for each period is connected to the next,without regard to other values for that period, such as the high or low. (Source: eSignal, www.esignal.com)

to expect more sophistication in the charts they view, even in free charts from newsand chart vendors. Accordingly, they have moved on to more complex charts read-ily available from a variety of sources.

Bar Charts Bar charts include quite a bit more information than line chartswith only a moderate increase in the complexity or busyness of the chart. Whilea line chart shows only closing prices, bar charts include the high and low pricesfor the period being viewed as well as the opening price and the closing price.

Figure 2.3 shows a daily bar chart with several sharp spikes up and down atcritical turning points and the channels that formed during trending periods. Eachbar is drawn between the high and low price for the period, and the open andclose are indicated with the small hash marks on the left and right side of the pricebar, respectively. Such details were lost on the line chart.

Again, as with any chart type, bar charts are used for many time frames, fromweekly and monthly down to intraday 60-minute or 1-minute periods. A bar chartcan even be drawn based on a specified number of price ticks, which creates many


FIGURE 2.3 Daily bar chart. Each vertical bar is drawn between the high and low for theperiod, and the opening and closing prices are indicated with the small hash marks.(Source: eSignal, www.esignal.com)

bars during hectic periods and few bars during quiet times. Which time frame ornumber of ticks to choose is up to you and will depend on how sensitive you wantyour charts to be.

Candlestick Charts Moving beyond the bar chart, some traders like a type ofchart with a more visual presentation of price relationships introduced to Westerntraders in about 1990. These are called candlestick charts because the body, repre-senting the difference between the opening and closing prices, looks like a candle,and the shadows, representing all the price action above and below the body dur-ing the time period depicted, look like wicks.

If the closing price is above the opening price, the body is usually clear, white,or green. If the closing price is below the opening price, the body is usually solid,black, or red. Candlestick charts provide a quick visual picture of the relationshipbetween opens and closes and their relative strengths or weaknesses, especiallyfor extended periods.

Figure 2.4 shows a daily candlestick chart with two of the many candlestickpatterns labeled.

A doji is a candlestick in which the opening and closing prices are about thesame, resulting in a short body, and the high and low prices for the period ex-tend above and below. It is most useful as a signal when it appears after a run-up in prices and may indicate market uncertainty, which often precedes a turnin the price trend.

A hammer is a candlestick in which the body is at the upper end of the trad-ing range for the period with little or no upper shadow; another shadowstretching out below the body is at least twice as long as the body. It oftenoccurs at the bottom of a downtrend and indicates a rejection of lows and areversal higher.

Another well-known candlestick formation (not shown on this chart) is a two-candle signal called an engulfing pattern. In the bullish version, the first candle isa black, red, or filled candle after a downtrend. The second candle is a white, green,or clear candle with the open below the first candles close and the close above thefirst candles open. In other words, the second candles body engulfs the first can-dles body and suggests the market is ready to change to an upward price direction.

Other colorfully named candlestick patterns include the hanging man, shoot-ing star, harami, and spinning top. What all of these candlestick formations looklike, what they mean, and how they can be used in trading is a study in itself thatgoes beyond the scope of this introductory text. Some patterns involve only onecandle; others require several candles. In all cases, much of the interpretation de-pends on where the pattern occurs on the chart.

Point-and-Figure Charts A lesser-known charting technique is the point-and-figure chart, which is worth mentioning because of the interesting way it focuses


on price action and eliminates reference to time. Point-and-figure charts appear tohave a random series of Xs and Os across a graph instead of a price bar or candlefor each time period. They are popular with floor traders, who find them easy tocreate and update even during hectic trading conditions. Figure 2.5 illustrates thepoint-and-figure technique, which was more popular in the past than it is today.

A point-and-figure chart has two essential measurements. The first is the priceunit for each box on a vertical scale; the second is the number of boxes it takes toreverse a column of Xs representing an uptrending market to a column of Os thatrepresents a downtrend or vice versa.

To keep the illustration simple, this basic point-and-figure chart uses dailygold futures closing prices and assigns a value of $2 to each box and a reversalvalue of one box. It takes a price change of just one box or $2 to reverse from Xsto Os or Os to Xs. As long as prices continue to make new highs, you place an X ina box at each $2 higher increment, building up the X column. If the high is not highenough to put another X on top of the c

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